A couple of weeks ago, some members requested the creation of a set of fully optionable portfolios. These portfolios consist exclusively of stocks and ETFs for which you can buy associated options. To learn more about ETFs, please read my free book.
Today, I'm happy to announce the creation of the “Optionable Portfolios” for MoneyGeek’s regular members. By implementing one of these portfolios, an investor is effectively buying insurance against steep losses on those portfolios. In this article, I will explain how someone can set up a portfolio so as to protect against steep losses, and I'll discuss the pros and cons of this approach.
How Options Can Protect Your Portfolio
The Optionable Portfolios are built to facilitate a strategy known as the 'Protective Put', which is also sometimes called the 'Married Put'. Understanding this strategy requires an understanding of put options.
I've explained what a put option is in a previous article, but let me briefly summarize it here. A put option gives its holder the right, but not the obligation, to sell a stock at a predetermined price. For example, a put option on XYZ may stipulate that its holder can sell a share of XYZ for $10 until June 2016. Note that put options are sold separately from the underlying stocks.
The protective put strategy involves buying an equivalent number of stocks (or ETFs) and put options. Implementing this strategy limits the amount of money that the investor can lose on her stocks.
For example, let's say that an investor buys a share of XYZ for $15, and also buys the previously mentioned $10/June 2016 put option for $1. Then, regardless of what happens to XYZ's stock price, this investor can only lose $6 at most from this trade. To see how, let's imagine that XYZ crashes and its share price goes from $15 to $5 in June 2016. Since the investor holds a put option on XYZ, she can still sell the share at $10. If she sells, she will lose only $5 (for having bought XYZ at $15 and having sold it at $10) plus the $1 she paid to buy the option. While $6 might be a painful outcome for her, she has avoided the even more painful outcome of losing $10 on XYZ.
By implementing the protective put strategy for all of the stocks and ETFs in her portfolio, an investor can guarantee that her portfolio won't dip below a certain amount. While that may sound very attractive, there are some caveats and drawbacks associated with this approach that you should know about.
First, I've had to exclude from the Optionable Portfolios some ETFs found in the regular portfolios (chosen as a result of the value investing strategy) since it's not possible to buy options on those ETFs right now. For example, I've had to replace the CAPE, which outperformed the overall U.S. stock market by 2% per year for the past two years, with another ETF that will closely match the performance of the overall U.S. stock market. Therefore, I expect the Optionable Portfolios to slightly underperform the Regular Portfolios.
Second, implementing an Optionable Portfolio requires that your portfolio be above a certain size. Unfortunately, you can only buy options in multiples of hundreds, which means the minimum number of shares you can protect with a put option is 100 shares. If an ETF costs $50 per share, it will cost $5,000 to purchase 100 shares. If there are five such ETFs in the portfolio that each cost $50 per share, buying 100 shares of each will cost $25,000, and that still doesn't include the cost to buy all of the options.
Third, implementing an Optionable Portfolio will cost a lot in commissions. While buying ETFs doesn't cost anything if you use many of the online brokerages, buying options is another matter. On Questrade, for example, buying one put option contract (1 contract = a bundle of 100 options) costs $11, although buying each additional contract costs just a dollar more. For these reasons, I believe it doesn't make sense to implement an Optionable Portfolio unless you have at least $150,000 to invest on it.
Fourth and finally, implementing an Optionable Portfolio requires dealing with a lot of hassles. All put options expire, so if you want to keep protecting your portfolio with put options, you'll have to continue to buy new put options after the old ones expire. Also, the added complexity introduces more room for mistakes. Furthermore, this site currently doesn’t offer any tools to help you implement this strategy.
However if you're unfazed by all of the caveats and drawbacks I mentioned and you still like the idea of protecting your portfolio in this way, you could try to implement one of the Optionable Portfolios. If you're in this camp, I just have one practical tip.
Mind The VIX
As I mentioned in the previous article on put options, the price of the option is determined in large part by its implied volatility. If you're unaware of this, I highly recommend reading that article.
The implied volatility of the overall U.S. stock market is captured by a metric called the 'VIX'. You can find the current value of VIX using this link.
If you look at the long term history of the VIX, you'll see that its value has jumped up and down a lot. I believe that buying options make sense when the VIX is, at the very least, less than 20, but it would be even more preferable to buy when the VIX is below 15. If you buy options when the VIX is more than 20, I believe you'll be paying too high a price for options.
In summary, MoneyGeek’s regular members can now use the new Optionable Portfolios to implement the Protective Put strategy, which allows you to effectively insure against catastrophic losses. However, implementing the portfolio is costly, involves some hassles, and is complicated. I don’t recommend this strategy for most people, but some may feel that the pros of the strategy outweigh the cons.